Monday, May 2, 2011

Modern Monetary Theory implies re-organising central banks.

Supporters of Modern Monetary Theory (MMT) do not seem to realise that MMT requires a slight change in the split of responsibilities as between governments and central banks. Moreover, the new split of responsibilities would be more logical than the current typical split of responsibilities. (That’s the beauty of MMT: look at the economy from an MMT perspective, and everything falls into place in a thoroughly neat logical fashion!)

Anyway the reasons for the new split of responsibilities are as follows.

Supporters of MMT, like supporters of monetarism, Keynsianism, socialism, and every other set of ideas that ever existed, do not agree amongst themselves on every detail. But I’ll take MMT for the purposes of this article to consist of the following.

In a recession, the government / central bank machine should simply create or print more money and spend it (and/or cut taxes). And conversely, if inflation looms, the opposite should be effected: money should be reined in via extra tax (and/or reduced public spending), with such money being “unprinted” or extinguished. Put another way, given a recession, government should “net spend” (i.e. spend more than it collects from tax or borrowing.

This method of adjusting aggregate demand and inflation dispenses with the distinction between monetary policy and fiscal policy. And since under conventional arrangements, governments are responsible for fiscal, while central banks are responsible for monetary policy, adoption of MMT would require a slightly different split of responsibilities as between governments and central banks. So what then is the new split of responsibilities?

The answer is to have central banks (or indeed any committee of independent economists) responsible for deciding whether inflation is sufficiently subdued to warrant more net spending. The latter is an entirely technical question, and is best taken by technically qualified people, independent of politicians.

As to governments or elected politicians, they take the strictly political decisions, like what proportion of GDP is allocated to government, and what the make-up of government spending should be.

That arrangement is not VASTLY different to the current typical relationship between central banks and governments. But the flaw in the current typical arrangement is that governments can decide to abstain from collecting enough tax to fund expenditure: they borrow instead. That is normally seen as stimulatory (given constant interest rates). And as pointed out above, the amount of stimulation suitable at any point in time is a technical question, best left to qualified economists.

So, to repeat, the ideal arrangement is for the experts to decide on what degree of stimulus (or deflation) is suitable. That means removing from politicians the power to run up debt.

Of course economists do not have an unblemished record in predicting inflation, but they ought to be better at it than politicians.

Most monetary or fiscal policy on their own cause distortions.

An obvious question to ask in reaction to the above suggestion about dispensing with monetary and fiscal policies is whether such policies do not in fact have merits.

The answer is that most individual monetary or fiscal policies on their own are distortionary.

For example an interest rate change works (if it works at all) only via firms and households that are significantly reliant on variable rate loans. In contrast, firms that are mainly reliant on equity finance are not affected. And that does not make sense because the objective of any stimulatory effort should be to boost EVERY firm, not just specific types of firm.

Another example of a distortion arises with quantitative easing. QE works primarily by boosting the value of assets of the rich. Here again, what is the justification for bringing stimulus only via the rich, while ignoring the poor?

Of course SOME types of monetary or fiscal policy are NOT so distortionary. For example a payroll tax change works via EVERY employer and employee in the country. And a sales tax change is even less distortionary.

But even if fiscal policy is as non-distortionary as possible, it is still distortionary, and for the following reason. Where government spends more, and funds this with increased borrowing, this is pure fiscal policy. But the interest rate hike that ensues is itself distortionary, for reasons given above (unless you believe that the latter borrowing involves no crowding whatever).

Why distortions matter.

A distortionary policy involves expanding some sectors of the economy relative to others, and that entails employees shifting from sector to another. This has an unemployment increasing effect: it takes time to find a new job.

But worse still, anti-recessionary fiscal or monetary policies are normally reversed once the recession is over. So the above employees have to shift back again! The unemployment raising effect continues!

I’ve set out the above arguments about monetary and fiscal policy and the implications for central banks in more detail here:

Afterthought (14th May, 2011): Re the above suggestion that the central bank be responsible for the degree of stimulus coming from BOTH fiscal and monetary policy, George Cooper in his book “The Origin of the Financial Crisis” also suggests that this might be an idea (Ch 8, section 8.3.3).